SEC “Presence” Exams – Four Focus Areas

Andrew Bowden, Deputy Director of the Securities and Exchange Commission’s (“SEC”) Office of Compliance Inspections and Examinations (“OCIE”) and in charge of OCIE’s national examination program recently provided some new details[1] regarding OCIE’s examination program with respect to the over 1,400 newly-registered advisers to private funds.[2]

Mr. Bowden described the three phases of the current program as it relates to the SEC’s approach towards these newly-registered managers as follows:

  1. Engaging and informing the new registrant population on the SEC’s program and priorities (it is expected that all newly-registered advisers will, in the next few weeks, receive a letter from the SEC discussing these OCIE initiatives);
  2. Examining the new registrants; and
  3. Reporting to the interested parties at the SEC, such as the Division of Investment Management and the Commission itself, and among the registrant population regarding the findings of these examinations. 

Mr. Bowden described the examinations as “presence” examinations where the SEC staff would make their presence known to registrants who are newly-registered.  The “presence” exams are narrowly-focused, risk-based exams which will thoroughly concentrate on one or two issues in order to provide a first-hand assessment of the adviser’s control environment and operations.  It is anticipated that such thorough concentration on certain areas would prompt advisers to be diligent with respect to those other areas not covered in detail during a “presence” examination.

Advisers also should be aware that the SEC will still be conducting some of the more traditional examinations where the adviser’s compliance program as a whole is the focus.  In some regions, Mr. Bowden said that the SEC staff may possibly be able to examine all newly-registered advisers while in other regions with a high-concentration of new registrants, such as New York City, a “reasonable” number of registrants would be selected for these examinations.

Mr. Bowden noted that approximately 20 percent of the registered investment advisers prior to the addition of the newly-registered advisers were advisers to hedge funds.  Accordingly, the “presence” examinations would concentrate on those areas which, based on past experience, had resulted in the highest incidence of risk and deficiencies with respect to private fund advisers. The four primary areas of focus will be:

  1. Marketing and advertising which, in addition to marketing materials, includes the use of finders, disclosure of side letters with investors, representations made to investors and how they compare to an adviser’s actual practices, and how funds of funds describe their due diligence process with respect to underlying funds, among other things. Mr. Bowden stressed the importance of doing what you say you do. He noted that advisers often make representations about, for instance, their investment process that do not reflect the reality of their practices.  With respect to side letters, he noted that the representations and clauses in such letters are not always followed.  For instance, registrants do not always send the notices required by the terms of the side letters or meet their most favored nation obligations.  
  2. Portfolio management covering mainly trade allocation among clients of the adviser, in particular, fair allocation of limited investment opportunities.
  3. Conflicts of interest specifically reviewing revenue sources, expenses and payments to finders and other third parties, thorough disclosures regarding conflicts of interests, personal securities transactions, and transactions with affiliates. Mr. Bowden said that the SEC will closely monitor transactions where managers move securities and other investments from one fund to another.
  4. Safety of client assets. Interestingly, Mr. Bowden included here not only custody of client assets but also valuation of securities. He also reminded advisers that passwords and user IDs providing them access to client checking accounts and credit cards equal custody and the relevant custody rules apply. Mr. Bowden said that previous SEC exams found several advisers that engage in such practices when offering full services to their clients.

A number of our clients have recently gone through one of these narrowly-focused SEC “presence” exams.  If you are interested in additional information about the process and how best to prepare, please contact us.

[1] Mr. Bowden has been actively using his various speaking engagements to lay out for the industry what to expect concerning OCIE’s exam initiatives of newly-registered advisers. Recent speaking engagements included IA Watch’s 12th Annual Fall Compliance Conference, September 24, 2012 and  Practising Law Institute Conference on Operational and Compliance Requirements for Hedge Fund Managers, September 5, 2012.

[2] Approximately 60 percent of which are advisers to hedge funds and 40 percent advisers to private equity funds.